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Tuesday, June 17, 2008

Visiting the Smokeless Tobacco Players

Often overlooked, the smokeless tobacco industry still has some long-standing growing power. We’ll explore two top players in the U.S. market, and try to decipher who’ll come out on top in the headwinds an economic slowdown- and realize that taxes and political pressures also face the tobacco industry as a whole.

UST, Inc. (UST):First, UST is your essential vice stock as the holding company for two principal subsidiaries: United States Smokeless Tobacco Company and Ste. Michelle Wine Estates.UST produces and markets the premium brands of ‘dip’ – Skoal ® and Copenhagen ®.

There is no question they have a problem with growth drivers. This needs to be addressed before I would contribute my personal capital to the company. While Skoal has been rolling out various new brands of dip- including mild flavors like Citrus Skoal- designed to both convert smokers and add new younger consumers to their base. An older article I read on SeekingAlpha.com pointed out something that holds true today: It may be in UST’s best interest to diversify beyond tobacco and explore joint ventures and acquisitions. In fact, their winery division grew 25% on extremely high volume last quarter.

If we pull up the 6 month chart, we clearly see a trading range set up from $52 to $58.

Even if it continues to be bound to the range- its 4.6% dividend yield should please any investor and negate the price swings, especially on the ex-dividend dates. After all, many investors hardly look to tobacco stocks for fast money.

In an April 2008 article on MSN Money USSTC president Daniel W. Butler said:

"This marked the seventh consecutive quarter of premium volume growth. I am especially pleased to see that despite a challenging economy and new price value entrants, premium volume trends remain strong and there has not been an acceleration in the price value segment."

In fact, that’s not entirely true. Low priced smokeless tobacco has been gobbling up market share from UST for several quarters now, as this RealMoney.com article points out:

“UST has had significant losses in market share to rivals like No. 2 player Conwood, a unit of Reynolds American , which is focused on the price-value segment with its low-cost Grizzly brand. Ten years ago, UST owned more than 80% of the smokeless tobacco market. By late 2004, the company's market share had slipped to 68%. Today, it's less than 60% and trending down.”

And the trend has no reason to break, yet. Sure, there is ALWAYS brand loyalty. I’d be naïve to doubt that. But, if we are in a recession, you can bet that the discount dip will creep its way up the income brackets.

That leads us to the primary discount player, Reynolds American (RAI):

R. J. Reynolds Tobacco Company is the subsidiary of interest here. It is much more diversified within the tobacco industry. They are primarily well-known for the Camel® and Kool® cigarette brands. Although in 2006, they acquired the rights to both the Grizzly and Kodiak brands of smokeless tobacco. RJR Tobacco Company is considered the second largest manufacturer of smokeless tobacco in the United States.

These two discount moist snuff brands are becoming increasingly popular and gaining market share on UST.

Again, let’s pull up the 6 month chart of RAI:

Despite the 6.5% yield, RAI is trading around its 52-week low of $51.08. RAI has been taking hits in the headwinds of analyst downgrades and lowered guidance, but trading flat since May 1st. This is not the Conwood division’s fault; the producer of the discount dip posted double digit volume growth, according to the Winston-Salem Journal. In fact, Conwood has huge growth opportunities, making up only 4% of revenues in 2006. RAI should follow in UST’s footsteps and start to market more varieties of their discount products.

Is it time to try to catch a bit of a, I don’t know, let’s call it a falling butter knife? Execs must think so after initiating a $350 million buyback program for the forward twelve months. RAI has a strong balance sheet; lots of cash, in other words, your 6.5% yield is safe. Now, time your entrance point right or cost-average down and you’ll mint money.

One last though to ponder: Altria (MO), better known as Philip Morris USA, is testing their own smokeless tobacco product. If market penetration proves difficult for big MO, will either subsidiary be ripe for acquisition by the tobacco giant? Would not be a big surprise to me.